Market failure and where it comes from

Meaning of market failure. Markets are usually a good way to organise economic activity: guided by prices, buyers and sellers pursuing their own interest are led to an outcome that serves the economy well. Market failure is the case where this breaks down, so that buyers and sellers left to themselves do not arrive at the efficient quantity of a good: too much of it is produced or used, or too little. This is why government can sometimes improve on market outcomes.

Sources of market failure. The examples are our own.

• Externalities. An action may benefit or harm others who are neither paid for the benefit nor compensated for the harm, and no market exists for such effects. A stone-crushing unit whose dust settles on nearby homes does not count that harm, so it produces too much; goods such as education and health, which benefit others too, are produced in too small an amount if left to individuals.
• Public goods. A good that no one can be kept from using, and whose use by one does not reduce it for others, invites people to enjoy it without paying (free riding); left to the market it is supplied in an inefficient quantity. A town's flood siren is an example.
• Common resources. A resource that anyone can use but that is reduced by each use, such as sand in a riverbed or free parking on a crowded street, is used beyond its efficient level because each user ignores the harm to the others, the tragedy of the commons.
• Rules not enforced. Markets cannot work efficiently unless the government enforces its rules and keeps law and order, so that sellers are sure of being paid for what they sell; over-use of a common resource, likewise, can be ended by clearly defined property rights.

Conclusion. Market failure means that a free market does not produce the efficient quantity. Its main sources are externalities, public goods, common resources and the absence of enforced rules.